Maintain the External Balance of the Metallic Standard - dummies

Maintain the External Balance of the Metallic Standard

By Ayse Evrensel

External balance of the metallic standard implies that the fixed exchange rate is maintained. The most important variable that may prevent the maintenance of the fixed exchange rate is the current account. Because the discussion about the external balance under a metallic standard involves the balance of payments, you first need some basic knowledge about the major components of the balance of payments.

The balance of payments (BOP) contains a country’s transactions with the rest of the world. These transactions include international trade (exports and imports) and the flow of short- and long-term capital. Therefore, the BOP has two main components: current and financial accounts:

  • Current account: Includes mainly exports and imports (as well as items called invisibles, such as tourism and workers’ remittances).

  • Financial account: Contains purchases and sales of foreign and domestic assets as well as investments.

In a metallic standard such as the gold standard, the BOP has a prominent role. In this particular monetary system, the central bank fixes the gold parity (the relationship between the price of gold and the currency). But to establish the gold parity, the central bank needs adequate gold reserves to maintain the gold parity.

Maintaining external balance means trying to avoid significant changes in these gold reserves. Under a metallic standard, safeguarding the fixed exchange rate and maintaining the stability of gold reserves — in short, maintaining external balance — is accomplished by the BOP with the help of the price–specie–flow mechanism.

Here is the definition of this mechanism and how it helps achieving the external balance. First of all, the term specie refers to the precious metal — for example, gold. Therefore, the price–specie–flow mechanism explains the relationship between money as a precious metal, prices, and international transactions such as trade and capital flows.

Second, the mechanism implies that money supply (as specie), prices, and the BOP are related. If a country runs a current account surplus and accumulates specie, prices in the country will increase, making this country’s goods more expensive to foreigners. This situation will then reduce the current account surplus in the home country and the current account deficit in the foreign country.

Under the classical gold standard and without a central bank (as in the U.S. until 1913 when Congress created the Federal Reserve System), the price–specie–flow mechanism did work pretty much this way. People took gold to the government and got money, then spent it. However, it worked this way less in the U.K. because the Bank of England could accumulate reserves and not increase the money stock.

In a metallic system, some countries may face persistent current account surpluses or deficits. For example, if a country runs persistent current account surpluses (exports exceed imports), its central bank accumulates gold, which revalues the currency. But under the fixed exchange rate regime, this situation can’t be allowed.

One way to reduce the amount of reserves is to engage in international lending. On the other hand, if a country runs persistent current account deficits (imports exceed exports), its central bank would lose gold reserves, leading to devaluation. To avoid devaluation, this country either attracts funds or borrows.

Even though borrowing (in times of current account deficit) and lending (in times of current account surplus) is assumed to reduce the pressure on the fixed exchange rate, they could be problematic as well.

Suppose a country with large and persistent current account deficits tries to avoid devaluation of its currency by borrowing. Increasing borrowing may lead to payment difficulties, which in turn would increase the cost of borrowing (with higher interest rates on loans).

Such problems may even lead to the country’s exclusion from international capital markets. Large and persistent current account surpluses are not desirable either. In this case, international lending may adversely affect domestic investment by decreasing it.